Chapter 4. Markets - University of Torontohomes.chass.utoronto.ca/~jheath/text/MMch4.pdfChapter 4. Markets The fact that ... interests of others in order to ruthlessly further their

Chapter 4. Markets

The fact that economic activity, throughout most of human history, has been organized as

a system of moral obligations and entitlements helps to explain why people have generally

believed that a set of shared values is essential for the maintenance and reproduction of social

order. If there was one lesson to be learned from history, it seemed to be that duty, honour,

loyalty and obligation were the "glue" that held societies together. This idea was, in many

people's minds, the first and most fundamental principle of politics and association. Furthermore,

as Hobbes's analysis of the state of nature showed, there was a significant element of truth in this

view. Without trust, even the most basic human relationships are impossible -- no matter how

beneficial they may be for all parties.

Understanding how deeply ingrained this idea was makes it easier to understand how

profoundly shocked Europeans were when a group of prominent English philosophers, including

John Locke, Adam Smith, and – more polemically – Bernard Mandeville, began to argue that

society could in fact get by with a lot less morality than had previously been assumed. The basic

idea, which all three of them shared, was that if you simply assigned a set of property rights to

individuals and then prevented them from violating each other's rights, you could leave them free

to do whatever they wanted without having to worry about it generating any deleterious social

consequences. In fact, far from having adverse effects, their actions would actually generate

benefits that everyone in the society would come to enjoy. So not only would less morality not

be a bad thing, it might even be a good thing. Mandeville (1724) captured this idea in his

seemingly paradoxical formula: "private vices = public virtues."

This claim is, to say the least, extremely counterintuitive. Anyone who has the slightest

bit of experience in human affairs knows that when individuals systematically disregard the

interests of others in order to ruthlessly further their own, it is unlikely to promote harmony or

general happiness. Even in our own day, in which people are much more used to the idea of

individuals rights, many still have trouble believing that the pursuit of self-interest can generate

any public benefits. When they hear the arguments of Locke and Smith, they assume that it must

be some kind of trick. But this initial reaction should not obscure the fact that there is a major

element of truth in their views. What the English political economists claimed was that in a

Normative Economics/Chapter 4 102

society with property rights, but no other form of normative control, a set of markets would

spring up through which all goods and services could be exchanged. Where such a market exists,

and its fundamental rules are respected, self-interested action does in general promote Pareto-

superior outcomes, because it is only possible to benefit yourself in trade relations by offering

others something that will benefit them. And it happens to be that case that when the system of

markets is "complete," so that all transactions are voluntary, the outcomes it produces will be

Pareto-optimal (although the meaning of "complete" is tricky, and will not be properly specified

until the next chapter).

It is therefore one of the major discoveries of English political economy – and of English

society more generally – that one can permit a selective "decline" in morality, without having

society fall apart. To put this more precisely, there is no need for any centralized authority to

micromanage the details of economic interactions. Central authority is only required in order to

create the system of property rights and provide ongoing enforcement of contracts. Everything

else can be achieved through decentralized individual decision-making. This is the trick at the

heart of the capitalist economic order. What capitalist institutions manage to do, when they

function correctly, is harness the free-rider incentives that, in the state of nature, serve to worsen

the human condition, and use them to increase both the productive capacity and the allocative

efficiency of the economy. The "race to the bottom" is thereby transformed into a "race to the

top." The way that markets accomplish this is very clever, and understanding how it works is

absolutely fundamental to understanding how the explosion of wealth and prosperity that created

modern societies came about. Understanding how markets work is also essential for

understanding how the personal freedoms that we now take for granted came to be

institutionalized. The fact that our society is able to get along with less morality means that we

are able to live with significant disagreements over substantive questions of value. This is one of

the reasons why capitalist societies are able to accommodate such unprecedented levels of

cultural and religious pluralism.

Unfortunately, because this "discovery" sounds so unlikely, proponents of capitalism

have had a marked tendency to overstate their case. It is very difficult to convince people that

markets have the virtues that they genuinely do have. It is often hard to imagine that haggling,

price-gouging, profit-seeking, usury, or any of the other rough-and-tumble practices of the

marketplace have beneficial social consequences. As a result, proponents of the market have


been very reticent to admit that the market pattern of organization has any flaws or limitations.

Furthermore, there is a very powerful streak of utopian thinking – highly concentrated in

economics departments – which claims that markets eliminate the need for any kind of moral

constraint. This has given the debate over markets ideological and often quasi-religious

overtones. The end of communism and the development of the welfare state have done a lot to

cool down this discussion. This makes the political climate much more propitious for a balanced

examination of both the advantages and disadvantages of the market pattern of organization.

Most Western societies seem to be settling into a long-run equilibrium in which about 60

per cent of the economic activity in the society is managed in the "private sector." Of this private

sector output, approximately two-thirds is produced by very large corporations, which use

bureaucratic decision-making structures, rather than markets, to allocate internal resources. As a

result, markets do less than half of the work of integrating economic activity in a modern

capitalist economy. It is crucial therefore that one not make sweeping statements that would

either overstate or understate the importance of markets in our lives. The following analysis is

therefore divided into three chapters. The current chapter deals with markets, the next looks at

corporations, and the following examines the economic role of the state.

The operations of a market economy can be analyzed in two dimensions: first, the way

that it organizes the allocation of goods and second, the way that it organizes their production. In

both cases, the system of property rights establishes a framework within which individuals can

compete with one another in order to secure opportunities to trade. In order to understand how

markets work, it is therefore important to begin by examining the structure of competition, then

look at the benefits of trade. Markets can then be analyzed as an interaction structure that arises

when competition and trade are combined.

4.1 Competition

One of the limitations of the moral economy is that, while it succeeds in removing the

disincentives people have to produce social goods in the state of nature, it does not supply them

with any positive incentive to produce more than is needed to satisfy the minimum requirements

of the society. For instance, consider a village whose primary food source is corn that is grown in

a large "commons." In the fall, the corn is harvested and divided out evenly among the

inhabitants of the village. In the state of nature, this sort of economy would be unsustainable. If


the corn is given to everyone, regardless of whether they worked the field, the free-rider

incentive would prevent anyone from ever working the corn field. If corn is only given to those

who have worked the field, then the shirking incentive would prevent the field from yielding

more than a bare minimum. A moral economy is able to bring society out of the state of nature,

by making it obligatory that everyone work the field, or that everyone work at a high intensity

level. Instilling a "work ethic" allows the society to avoid the underlying collective action

problem.

But even if every member of the society internalizes these rules, and so goes out every

day and puts in an honest day's work, there is still an incentive problem. While everyone is

motivated to comply with the rules, no one has any incentive to do anything above and beyond

the basic requirements. Rather than maximizing production of the social good, individuals

engage in what economists call satisficing – they do just enough to satisfy the rule, then they

stop. This means that while the moral economy is able to secure production, it does not provide

any incentive to expand production. For instance, the workers have no incentive to look for

better ways of cultivating the corn, because the advantages that would come from such an

improvement would be dispersed across the entire society, while the costs of developing the

technique would be born by them alone. (This is just another collective action problem:

productive technology is a social good, since anyone can copy it. Thus the benefits of improved

technology largely take the form of positive externalities. This means that individuals seldom

have an incentive to shoulder the costs needed to improve it. This is why the creation of patents

– a form of intellectual property right – in the 19th century led to an explosion of new invention

[Landes, 1998].)

Because of this incentive problem, moral economies tend to persist in a kind of steady-

state. Moral rules can ensure that people generate positive externalities, but they cannot require

that people think up new ways of generating positive externalities (and even if they did, the rules

would be unenforcable, precisely because these new ways have not been thought up yet). As a

result, it is possible for there to be fairly obvious improvements that are never implemented,

simply because people lack the motivation to do so. Of course, there will always be some people

who derive satisfaction from innovation and improvement. The point is simply that in a

productive arrangement of this type, the economic incentives work against them. This is why

traditional societies tend to be economically stagnant (i.e. they generate a cooperative surplus


that allows the society to persist, but the size of the surplus has no tendency to increase).

Stagnant is not necessarily bad, and lots of people are perfectly happy with it. But the presence

of unexploited technological gains is inefficient. It means that some people could be made better

off, without anyone being worse off, if only the incentives could be arranged in the right way.

The major advantage of growth in the size of the cooperative surplus, apart from the fact

that it makes more resources available for consumption, is that it can increase the productive

capacity of the society, thereby reducing the amount of work that it takes to produce the same

surplus in the following year. From a material perspective, the fact that our society is wealthy is

entirely due to the fact that our ancestors, instead of spending all of their time producing

consumption goods, chose to spend some of it producing tools that would make the production of

consumption goods less time-consuming. This then freed up more time the next year to produce

more goods, as well as more tools. Once the pattern of growth is established, the wealth of the

society tends to amplify over time (this is sometimes referred to as an "autocatalytic process").

The more wealth you have, the more you can invest in tools that will, in turn, make it easier to

produce more wealth.

The portion of the society's wealth that is not consumed, but rather used to build

additional productive capacity, is referred to as investment. Investment, however, tends to

produce only social goods. Once a new technique is discovered, or a new tool produced, anyone

can use it. For example, suppose that a group of hunters get very lucky one year, and catch so

much game that have enough food for the rest of the year. Now that everyone has some spare

time, individuals might use it to think up some better ways of catching their food, e.g. they might

try to invent a better bow and arrow. If they succeeded in inventing a better bow, it would mean

that in the following year, they would no longer need luck in order to reproduce the large

surplus. But the advantages that would flow to the individual from spending time on such

pursuits may simply not be worth the value of the foregone leisure. The significance of the

incentive problem that this creates should not be underestimated. Many hunter-gathers, despite

living a somewhat precarious existence, punctuated by periods of famine and starvation, have

been reported to live quite leisurely lives, often working only every other day, and usually no

more than four to six hours per day (Schor 1992, 10).

It has been well-known for a long time that while rules may be effective at getting people

organized, they do not in general to promote excellence. They encourage satisficing, rather than


maximization. One of the ways around this problem, discovered a very long time ago, is to stage

a competition. A competition is essentially a rule-governed interaction, structured in such a way

that the individual's self-interest is made to coincide with the general interest. The key point is

that rules are used, not to impose specific obligations upon individuals, but to restructure

incentives so that individuals can get something else that they want only by fulfilling these

obligations. For example, every military commander wants his soldiers to be strong and fit, to

have superior fighting skills, etc. However, the conditions of old-fashioned hand-to-hand combat

made it very hard to tell who was pulling their weight and who was shirking. One easy solution

was to organize contests among the soldiers, to see who could run the fastest, jump the furthest,

lift the most, etc. A competition is simply an institution that imposes a set of rules that determine

how the winner will be selected, which strategies are permissible, and what rewards will flow to

the victor (either symbolic or material). The Olympic games – in their classical form – are an

institution of precisely this type.

The thing that distinguishes a competition is that, in order to win, you have to be more

than just good, you have to be better than everyone else. In contemporary sports jargon, your

"personal best" is worth nothing, all that matters is being the best. Because each competitor's

goal is defined as doing better than everyone else, the interaction has the structure of a

prisoner's dilemma. Everyone wants to train just a little bit harder than everyone else, to push

themselves just a little bit further than everyone else. As a result, everyone trains harder, pushes

themselves further. But this just "raises the bar," so that whoever wants to win has to train harder

still, push themselves further still, etc. The only equilibrium is the point as which the biological

limits of the human species have been reached (and even that appears subject to modification).

So imagine a military commander who offers something very valuable – say a gold medal

– to the soldier who can run the fastest. The soldiers are now facing a collective action problem.

In general, they would rather lounge around in the barracks than do sprints around the camp.

Suppose they realize this, and develop an informal pact – "we'll all keeping lounging around, and

then when the day of the competition comes, the medal will just go to whoever happens to be

fastest." But this gives everyone a free-rider incentive. If the others are going to lounge around

the barracks, then the one person who sneaks out and trains on the sly will be very likely to win.

But if others are going to be training, then it is essential to train as well, in order to have any

chance of winning. So either way, everyone is better off breaking the agreement and training. In


terms of the soldier's own preference for leisure over training, this makes the outcome

suboptimal. (In the same way, students would be better off if no one took LSAT or GRE prep

courses. But as long as some are, everyone else feels pressure to do so as well, in order to retain

at least relative position.)

The result of athletic competition for the society at large is excellent – they get a slim and

trim military whose legendary speed and prowess will deter any invasion. The competition

thereby harnesses the incentive structure of the prisoner's dilemma, and uses it to provide a

social good. Better yet, it arranges things so that people try to outdo each other in providing this

good. Thus "healthy" competition creates a collective action problem among the competitors, so

they can't stop themselves from doing something that is uncomfortable for them, but that

generates benefits for the rest of society.

It is important to keep in mind, however, that a race to the bottom has exactly the same

structure as a race to the top. Preparing for a GRE test is a race to the bottom, since it does not

involve learning any useful skills other than test taking. Preparing for the final exam in a course,

on the other hand, has at least putative social value (insofar as it increases average level of useful

learning), and is therefore a race to the top. But both competitions have exactly the same

incentive structure. This is something that people sometimes forget. Competitions sometimes

generate such high levels of excellence that many people start to think of competition as a good

thing without qualification. But in itself competition is not a good thing. Competitive behaviour

always generates negative externalities for the people against whom one is competing. This is

why most people hate it when their friends or co-workers start to "get competitive" with them.

But it is this negative externality that creates the incentive structure that forces a constant

escalation of individual effort. In cases where the action that generates the negative externality

for the other competitors also generates positive externalities for members of the society at large,

then the race to the bottom among the competitors has beneficial social consequences that

outweigh the losses.

For example, when one soldier trains a little bit harder, this creates a negative externality

for all those against whom he is competing, since it decreases their chances of winning a medal.

But it generates a positive externality for society (and even the soldiers), in the form of increased

fitness in the military. So when the soldiers train to outcompete each other in the races, it is as if

they were competing to produce the fittest possible military. But it is important to keep in mind


that this is not what they are actually doing. From the standpoint of the competitors, these

positive externalities are achieved "accidentally." It is important therefore not to think of the

competitors as either virtuous or vicious. Whether not a competition is good, or "healthy," does

not depend upon the character of the competitors, but upon the design of the rules the structure

the competition. A good competition is one whose rules are organized so that individuals can

only win by doing something that benefits other people.

A competition that has beneficial consequences can easily become harmful if it escalates

too far. Robert Boyd and Peter Richeson discuss the case of a society in which individuals

compete with one another in order to grow the largest yams (1985, 269). This competition was

obviously instituted in order to give individuals an incentive to increase their agricultural yields.

Unfortunately, so much status got associated with yam-growing, and the yams got so big, that

individuals began to spend an inordinate amount of time growing giant yams, sometimes to the

neglect of the nutrutional needs of their own families. Furthermore, the yams got impractically

large, often requiring as many as 12 people to carry them. In the end, an enormous amount of

time and energy was spent growing a "status vegetable" that had no redeeming social value. If

people in this society had decided just to call off the yam competition, everyone would have

been much better off. In this way, the giant yam came to resemble the peacock's tail. The race to

the top became a race to the bottom.

For this reason, competition must be monitored carefully. There are two dangers always

present in any competitive interaction:

• Deviance. First of all, the only thing that stops every competition from degenerating into a

state-of-nature free-for-all is the set of rules that constrain the set of permissible competitive

strategies. For instance, if athletes decided that instead of training, they would just hire thugs to

injure their competitors, then athletic competition would lose any redeeming social value. It is

therefore very important to keep in mind that not only is every competition an institution, i.e. a

norm-governed activity, but that every competitor always has an instrumental incentive to break

the rules. This is why a social practice like athletics, despite having an internally competitive

structure, is externally constrained by very powerful forms of normative control. For instance,

the expectation that people should be "good sports," or not engage in "unsportsmanlike conduct,"

is very strongly sanctioned. (In fact, one of the reasons that sports are thought to "build


character" is that it is so difficult, in the heat of competition, to resist breaking the rules or being

a bad sport.) Thus the gains in motivation that are achieved through competitive behaviour must

always be counterbalanced by the need for constant vigilance in enforcing the rules that give the

competition redeeming social value. Competitors must remain constrained utility-maximizers,

not straightforward utility maximizers.

• Excess. The second major feature of competition is that there is a built-in tendency for

participants to get "carried away." Getting carried away means pursuing the competition beyond

the point where it produces any positive externalities (and even to the point where it begins to

produce negative ones). The giant yams are a good example. No one is breaking the rules, but the

competition has just gotten out of hand. When they first began to be used, performance-

enhancing drugs in athletics provided another good example. If one person goes on steroids, then

everyone else has to go on steroids just to stay even. But this changes the nature of athletic

competition, so that instead of seeing who has the most ability, the competition only determines

who has the best doctor. The latter is widely regarded as pointless. In both of these examples, the

reason that the competition gets carried away has to do with the fact that the competitors are not

doing what they do because its has redeeming social value, they are doing it because they want

to beat the others. As a result, when the competition ceases to have redeeming social value, this

does not give any of the competitors any incentive to stop what they are doing. In a sense, they

act "myopically" (although it is important to keep in mind that they act the way they do because

of a free-rider incentive, not because of any tendency to privilege their short-term interests over

their long-term). It takes someone from the outside to intervene and call off the contest, or else

impose new rules.

It is therefore important not to romanticize competition. Competition is, in philosophical

terms, prima facie bad (i.e. presumed bad until proven otherwise), because every competitive

outcome is suboptimal for the competitors. However, under very specific institutional

circumstances, competitions can be used to generate positive externalities that will outweigh the

negative externalities that competitors generate for each other. If the competitors derive some

benefit from these positive 'externalities' as well, then the overall outcome may be a Pareto-

improvement. However, competition will always have a tendency to break through these


instititional boundaries and become a race to the bottom. As a result, it must be constantly

monitored and reevaluated.

Despite the danger that it will become destructive, competition is valued across the world

for its extraordinary motivational power. Every human society with a recorded history has been

known to make use of competition in one way or another to motivate people. Instead of just

ordering people to go out and pick the corn, you can stage a competition to see who can pick the

most corn. Instead of giving away your son to just any woman, you can have a competition to see

who will offer the largest dowry. Instead of ordering your soldiers to march faster, you can stage

a race to see who gets to the camp first. And so on and so on. Competition is ubiquitous in

organized social life. Thus competition, despite drawing upon what are essentially anti-social

tendencies, has an important role to play in society. As Kant observed:

Without these asocial qualities (far from admirable in themselves) which cause the

resistance inevitably encountered by each individual as he furthers his self-seeking

pretensions, man would live an Aracadian, pastoral existence of perfect concord, self-

sufficiency and mutual love. But all human talents would remain hidden for ever in a

dormant state, and men, as good-natured as the sheep they tended, would scarcely render

their existence more valuable than that of their animals… Nature should thus be thanked

for fostering social incompatibility, enviously competitive vanity, and insatiable desires

for possession or even power. Without these desires, all man's excellent natural capacities

would never be roused to develop (Kant 1784, 45).

4.2 Trade

Historically, markets developed out of the practice of long-distance trade. Within a moral

economy, the circulation of goods was subject to very tight normative controls. People could not

trade goods at their leisure. For instance, one of the paramount rules of gift-giving is that you are

not allowed to "re-gift." The morality of gift-giving requires that recipients keep gifts that they

receive, even if it not something that they particularly want (this is why most of us have closets

and cupboards full of useless presents that we hold on to out of politeness). Even in a feudal

hierarchy, exchange relations were subject to direct political control. Peasants were not free to

"shop around" for the best seed, or the most competent blacksmith, they were expected to


conduct all commerce with the lord, or with the "guild" that was specifically authorized to

provide particular goods or services in their region.

Within a normatively integrated economy, however, long-distance trade presents

something of an anomaly. Trading with strangers means that there is no opportunity to develop

an extensive set of norms, and there is no common authority structure. Furthermore, the

interaction often involves a very low level of trust, because the participants may be unlikely to

ever encounter one another again. This fact has made many societies straightforwardly

xenophobic – they avoid all interaction with outsiders. However, it's not hard to see that there

can be enormous benefits from external trade. Foreigners may be able to supply goods and

resources that simply aren't available within a particular area. For example, the remains of

obsidian tools are scattered all across Canada, even though volcanic glass occurs naturally only

in the Rocky Mountains. The suggests a very extensive trade network, the reasons for which are

fairly obvious – prior to the introduction of metallurgy and glasswork by Europeans, obsidian

was the only substance that could be fashioned into a genuinely sharp edge.

The benefits of trade create a powerful incentive for people to work out some kind of

institutional arrangement to promote it. Thus the basic protocols of exchange are introduced:

people agree to not to seize each other's goods through force, but to induce others to part with

their goods by offering something in return. And since the people with whom one is trading are

strangers, one has no further obligation to them. As a result, the goal of exchange is to get the

most that you can in return for your goods.

When trade is conducted in this way, and when people are able to determine the quality

of the goods before they purchase them, trade always generates Pareto-improvements. Trade

does not increase the overall amount of wealth – the same amount of stuff is still there. But

because people may have different initial endowments, or different preferences, changing the

way the wealth is allocated can lead to greater levels of satisfaction. Thus if I live inland, and

someone else lives by the sea, I may choose to exchange some extra corn in return for some fish.

If we agree on a price of, say, twelve ears of corn in return for one fish, this shows that one fish

is of greater value to me than twelve ears of corn, and the opposite is true of my exchange

partner. (This is probably because I'm tired of eating corn all the time, and she's tired of eating

fish.) Thus the exchange represents a Pareto-improvement (in fact, that's exactly why we make

the exchange – we both prefer the post-exchange allocation to the pre-exchange allocation). It is


important to keep in mind, however, that this increase in efficiency is achieved without an

increase in the absolute amount of wealth. The quantity of goods does not change, it is just that

after the exchange these goods are better matched to needs. This kind of improvement is called a

gain from trade.

In an exchange, each person is behaving selfishly. However, the system of property rights

ensures that the only way anyone can improve her own condition is by offering someone else

something that will improve his condition. This means that you can only help yourself by helping

others (as opposed to the state of nature, where there is nothing to prevent people from just

killing others for their belongings). As a result, every self-interested exchange generates a benefit

for your trading partner. This is where the Pareto-improvement comes from.

Thus trade creates a more efficient allocation of goods. As a result, exchange provides a

generic mechanism that can be used in all sorts of different contexts to promote efficiency. To

see this, consider the following distribution problem. Suppose you are the chief of a society that

grows all of its food in a large, collective vegetable garden. All of the vegetables are harvested in

the fall, and you, the chief, are assigned the task of distributing them out to all the members of

the community. Being scrupulously impartial, you decide to give everyone exactly the same

amount. So you assemble a basket of vegetables for each person, putting exactly the same

number of carrots, potatoes, corn, and so forth, in each basket. But then, just before handing out

the baskets, you ask yourself, "Am I a good chief? Have I done the best that I can for my

people?" You then realize, with a sinking feeling, that the allocation of vegetables you are about

to implement is Pareto-suboptimal. That is to say, under the allocation you are proposing, some

people will be worse off than they would be under some other feasible allocation, without

anyone else being made better off. What made you think of this is your recollection that Fred

hates carrots, and that Susan is allergic to potatoes. This means that you could give Susan's

potatoes to Fred, and Fred's carrots to Susan, and they would both be better off.

Once you start thinking this way, you realize that everyone has slightly different

vegetable preferences, and so, if you wanted to make everyone happy, you would have to give

them each a basket that was specifically tailored to their particular needs. You then realize that

figuring out who should get what would involve getting everyone to fill out a very complicated

questionnaire, then constructing and solving an extremely complex set of linear equations. And

what if people don't tell the truth on the questionnaire? You begin to despair.


But your trusted advisor, who has been dabbling in foreign trade, makes an interesting

suggestion. Traditionally, people have felt obliged to eat whatever the chief gives them, in order

not to seem ungrateful. Your advisor suggests that you give everyone an identical basket of

goods, but then encourage them to trade with each other, exchanging anything they don't want

for something that they do. That way, Susan can just exchange her potatoes for Fred's carrots,

and you don't have to worry about it. Instead of having to figure out who likes what, you can just

let the people sort it out themselves. The beauty of this proposal is that as long as some people

have vegetables that they don't especially want, trading will continue. People may keep trading

until there are no further gains from trade to be had. But since every gain from trade is a Pareto-

improvement, this means that trading may continue until a Pareto-optimal allocation of

vegetables has been achieved. Your people, without even knowing it, will have done your job for

you.

(Incidentally, gains from trade are a sufficiently obvious source of improvement in

quality of life that even completely moral allocation systems, like gift economies, will tend to

generate "black markets," in which people surruptitiously exchange goods. But this does not

show that there is some natural human "propensity to truck and barter." Even in our own society,

the sitution in which goods can be freely exchanged in order to effect Pareto-gains is quite

sharply delimited by social norms. For instance, most people are highly reluctant to swap food

from their plates in restaurants, or buy leftover wine from people at the table next to them. The

result is that restaurants throw away a staggering amount of perfectly good food. Thinking about

the amount of readjustment it would take to get restaurant patrons to freely exchange food is

helpful in trying to imagine the way our ancestors initially responded to the suggestion that other

kinds of goods, like land, should be bought and sold on the market.)

But despite the fact that trade will clearly generate Pareto-improvements, it is not obvious

that it will generate a Pareto-optimum. In order to get a Pareto-optimum, not only must every

beneficial exchange occur, but every exchange must also be the most beneficial. This will not

necessarily happen. Most obviously, it is not clear that everyone who wants to sell something

will be able to find a buyer. Furthermore, the set of trades needed to redistribute the goods may

be extremely complex. In general, not all Pareto-improvements will be such that they can be

achieved through a single bilateral exchange (like Susan and Fred swapping carrots for potatoes).

Susan may have something that Fred wants, but Fred may have nothing that Susan wants.


Exchange will only occur if Fred can find some third person who does have something that

Susan wants, and who wants something that Fred has. But it is not obvious that a sequence of

bilateral exchanges can be "chained" together to produce every Pareto-improvement. This is not

to say that it isn't true. It merely isn't obvious; it is something that needs to be shown. And

showing it requires some additional vocabulary.

4.3 Supply and Demand

The conditions that must be in place in order for a Pareto-optimum to be obtainable

through trade are easiest to formulate using the notion of price. In order to assign prices to

goods, all that one need do is take one good that is being exchanged and express the value of

everything else in terms of the amount of this good that it can purchase. Since this one good is

being used to "keep count" of the value of every other good, it is referred to as the numéraire.

Although in principle any good could be used for this purpose, in practice people tend to select

goods with specific properties. Whenever there is one good that everyone always wants (because

it is very useful, very scarce, doesn’t spoil, etc.)., everyone will always be willing to accept it in

return for goods that they want to sell. If this good also has properties that make it easy to use to

keep count (such as uniformity, divisibility, durability, etc.), then it is an excellent candidate.

Goods that have played this role historically include salt, coffee beans, and a variety of precious

metals.

While the introduction of numéraire money facilitiates transactions, it also makes it

possible to replace one-on-one trading with a uniform price system. Instead of having to find

someone with something that you want, who also happens to want what you have, you can

simply offer your goods at a certain price, then use the money you earn to shop around for things

you want. Thus instead of having a decentralized trading system, one can organize a central

market. People looking to sell on this market will offer goods at particular prices, just as people

looking to buy will make counteroffers. When they settle on the terms of exchange, it has the

effect of specifying a price for that commodity. The question of Pareto-optimality can then be

formulated as follows: is there a set of prices at which all goods that are offered up for sale are

bought? If the answer is yes, this shows it is possible for every trade that can be be made to be

made, and so for Pareto-optimality to be achieved through exchange.


When people get together to trade, one can think of them as producing two different

"pools" of good. The first is the supply pool, which consists of all the goods that people are

willing to sell. The second is the demand pool, which is a sort of virtual collection of goods that

people want to buy. In a typical market, the supply pool is usually the collection of goods that are

on display, while the demand pool is the set of goods on people's shopping lists. When there is a

perfect match between the supply pool and the demand pool, the market is said to have been

cleared. The price of any particular good at the point where the market for that good clears is

referred to as the market-clearing price. A Pareto-optimal allocation of a good will therefore be

achieved when a price is reached that clears the market for that good.

In order to see how this might occur, it is helpful to draw supply and demand curves.

The simplest kind of demand curve shows how much of a particular good a particular individual

will buy at each different price level. Figure 4.1 shows a typical "downward-sloping" demand

curve. The curvature indicates that as the price drops, the amount that the buyer is willing to

purchase increases. (The line is referred to as an indifference curve, because at each point on the

line, the buyer is indifferent between the quantity of the good to be purchased and the quantity of

money being offered.) The reason that the quantity demanded decreases as the price increases is

that money spent on one thing is money that can't be spent on something else. In order to buy

carrots, the buyer must renounce all of the other things that she could have bought instead (this is

called the opportunity cost.) As the price of carrots goes up, the bundle of goods that could be

bought instead of carrots gets larger and larger, making it more attractive to the buyer. This

means that she can increase her utility by reducing carrot consumption and substituting other

goods.


price

quantity

Once price gets too high, quantity demanded drops to zero

lict of inte

x

p

At price p, quantity demanded is x

lict of

Figure 4.1 Demand curve

The attitude of the person selling can be represented in the same sort of way. Figure 4.2

shows a typical supply curve. In order to decide how much to sell, each individual seller must

consider how much he can expect to get for his goods. For example, if I dislike carrots, I will

want to sell them no matter how much I get for them. If, however, I am lukewarm about beets,

then how many of them I choose to sell will depend upon how much I can get in exchange for

them. If other people really like beets, and so would be willing to give me a lot in return for

them, then it may be worth my while to sell all that I have. But if beets are less popular, then I

may be better off holding on to some, because I may not be able to get anything better in return

for them. As a result, the supply curve will have an upward slope, as an increase in price

increases the quantity of the good that the seller is willing to supply.


price

quantity

Once price gets too low, quantity supplied drops to zero

lict of inter

x

p At price p, quantity supplied is x

lict Figure 4.2. Supply curve

This way of representing supply and demand shows that there is never really "too much"

or "too little" of a particular good in any absolute sense. At any particular price level, supply and

demand may be mismatched, but there is usually some price at which the two curves meet

(otherwise the two "meet" at quantity = 0). To see where this is, one can just superimpose the

demand and the supply curves in a single diagram, as in Figure 4.3. The point at which the two

lines intersect (x, p) represents the price that clears the market – x amount of the good will be

sold at a unit price of p.


price

quantity

x

p

D

S

Consumer's surplus

lict of inter

Supplier's surplus

lict

Figure 4.3 Market-clearing price

This type of graph also has the convenient feature of showing the monetary value of the

gains from trade achieved through the exchange. Suppose that x = 4, so the buyer purchases 4

units at a price of p per unit. Had she only been able to buy one unit, she would have been

willing to pay much more than p for it (this is reflected in the fact that the demand curve is

higher at that point). Suppose she would have bought one pound of carrots at a price of $7, 2 at a

price of $6, 3 at a price of $5, and 4 at $4. This means that when she pays $16 for the four

pounds, she is effectively getting a deal on the first three. For instance, while she would have

been willing to pay $7 for the first pound, she gets it for only $4. Thus the gain from trade on the

first unit is worth $3 to her. (Of course, she doesn’t get the money, what she gets is a utility gain

that is equivalent to the utility gain she would receive if someone simply handed her $3. Or to

put it in terms more familiar from §2.1, presented with a choice between making this trade and

being given $3, she would be indifferent.) The sum of these utility gains on every unit purchased

is referred to as the consumer's surplus, and its magnitude is equal to the area under the

demand curve and above the price line. In Figure 4.3 this is the lightly shaded region. The gain

from trade to the supplier is the region above the supply curve and below the price line (by parity

of reasoning, since the seller would have been willing to sell the first unit for much less than the

final price). This supplier's surplus is shown as the more darkly shaded region in the same

figure.


One can tell simply by inspecting Figure 4.3 that the price that clears the market is the

only one that generates a Pareto-optimal outcome. Since the buyer will never buy more than she

wants, no point to the NE of the demand curve can be achieved Similarly, since the seller will

never sell more than he wants to sell, no point to the SE of the supply curve will ever be

achieved. As a result, the portions of the supply and demand curves that border the shaded

regions of Figure 4.3 represent the only outcomes that could be produced through voluntary

exchange. If some price level other than p is chosen, this means that the quantity exchanged will

be less than x. Thus the supplier will be left with goods that he wants to sell, and the buyer with

money that he is still willing to exchange for those goods – just not at those prices. As a result,

there will be a potential gain from trade that the agents fail to capture.

This sitution is illustrated in Figure 4.4, which shows what happens when the seller

demands a price higher than p. At this price, the buyer is only willing to purchase x1 amount of

the good. The supplier manages to capture a portion of the consumer's surplus, but a certain

amount of consumer/supplier surplus is simply lost. This is referred to as a deadweight loss, and

is shown in the darker shaded region of Figure 4.4. The exchange represented by (x1, p1) is

Pareto-suboptimal because of this loss. Its presence means that after the exchange is complete,

both the seller and the buyer could be made better off if they exchanged more goods. Naturally,

they will not exchange anything further at price level p1. But they could make further, mutually

beneficial exchanges at a lower price. As long as the price is above p0, this will be true. As a

result, outcome (x0, p0) is the only one that cannot be improved upon through further exchange.


price

quantity

x0

p0

D

S p1

x1 x2

Consumer's surplus

lict of interest

Deadweight loss l

ict of inter

Supplier's surplus l

ict

Figure 4.4. Asking price too high

However, the fact that the market-clearing price is the only Pareto-optimal outcome does

not make it the only equilibrium. When there is only one buyer and one seller, every point on the

portion of the demand curve above the supply curve, and every point on the portion of the supply

curve below the demand curve, represents a Nash equilibrium. The reason for this is simple. If

the seller names a price, and the buyer believes that the seller will only sell at that price, then the

buyer is better off exchanging what she can at that price level. Similarly, if the buyer names a

price, and the seller believes that the buyer will only buy at that price, he is better off accepting

it. As long as there is some gain from trade on both sides, both parties have a reason to accept

whatever price they believe the other intends to exchange at. For example, if the seller asks for

$5, and the buyer believes that the seller will not sell for anything less, then she is better off

accepting this offer and purchasing 3 units (since it still provides her with a consumer surplus

with a value of $3). Since every feasible exchange is Pareto-superior to the status quo, players

can be expected to accept any one of them. Furthermore, one of the players is often better off at

one of the Pareto-suboptimal points. For instance, in Figure 4.4, if the shaded region under x1p1 is

larger than the shaded area under x0p0, the supplier gets a larger surplus selling at the higher price

than she would at the price that clears the market. As a result, one-shot individual exchange has

no tendency to generate Pareto-optimal outcomes.


Naturally, all this depends upon players believing that the other's offer is firm. This is

why haggling over prices in a shop or bazaar, where there is only one seller, often involves a lot

of posturing. The goal of this game is to convince the other person that the offer you have put on

the table is your final offer – if you are the seller, that you cannot go any lower, and if you are

the buyer, that you cannot go any higher. Since every pricing strategy is potentially in

equilibrium, you need only to persuade the other person that your announced “final price” is in

fact your final price. So merchants will claim that they will have to declare bankruptcy if they

lower their prices further, or that their children will go hungry. And buyers will pull out their

wallets to show that they only have a certain amout of money on them, and are incapable of

paying more. In this game, the person who can be the most convincing or hold out the longest

usually wins. And when this finally happens, there is no particular reason to believe that the price

chosen will clear the market.

4.4 Markets and allocation

Everything changes when multiple buyers and sellers are introduced into the trading

relation. The ability of the supplier to charge more than the market-clearing price, or of the buyer

to pay less, depends upon their ability to hold out against the other. Since many outcomes are

feasible, buyers and sellers will only agree upon a price when one of them comes to believe that

the other cannot be persuaded to change her price any further. But if more buyers and sellers are

introduced, they may begin to compete with one another for purchases or sales. When they do

this, every agent loses the ability to hold out. This is the primary benefit of marketplace

competition. If one seller tries to hold out for a high price, the other sellers will underbid him. If

one buyer tries to hold out for a low price, the other buyers will outbid him. As a result, the only

equilibrium price level in a competitive market is the market-clearing price, which also happens

to be the only price that generates the Pareto-optimal allocation of goods. This the key to the

success of markets: trade provides a source of Pareto-improvements, competition provides the

dynamic that drives individuals to exhaust all of these potential improvements.

In order to analyze the structure of this competition more closely, we must first construct

aggregate supply and aggregate demand curves. These represent the total supply and total

demand for a particular good in a particular population, and can be constructed simply by adding

up the supply and demand curves of each individual who is participating in the market. Figure


4.5 shows the intersection of two such curves. In this diagram, (4, $4) represents the only

equilibrium. To see why, consider what happens if the asking price starts above the market-

clearing price (at $6), or below (at $3).

price

quantity

1 2 3 4 5 6 7 8

8

7

6

5

4

3

2

1

equilibrium price

S

D

Figure 4.5 Price equilibrium

• Price starts at $6. If suppliers start out asking for $6, then they will only get offers to purchase

2 units of the good. Since the suppliers are willing to sell 8 units at this price, there is an excess

of supply over demand. This means that some individual suppliers will be left with unsold goods.

The big question then becomes who will get stuck with these unsold goods (or equivalently, who

will get what portion of the suppliers's surplus). This presents each individual supplier with an

opportunity. Rather than run the risk of getting stuck with unsold goods, he could just drop his

asking price slightly lower than his competitors, thereby guaranteeing that her goods will all sell.

The losses that he suffers from lowering the asking price will be made up for the larger portion

of the supplier's surplus that he will be able to capture. However, since the goal is to select an

asking price lower than one's competitors, and all suppliers are in the same situation, the

interaction has the structure of a race to the bottom.

Consider the following scenario for a competition between two carrot suppliers: each

supplier has the same individual supply curve. If the suppliers have the same asking price, the

consumer will purchase an equal amount from both of them. If one of the suppliers has a lower

price than the other, the consumer will purchase as much as he can at the lower price, moving on


the higher-priced supplier only if the lower-priced supplier runs out. The level of supply and

demand at each price point is as follows:

price aggregate demand aggregate supply

$4 4 lbs. 4 lbs.

$5 3 lbs. 6 lbs.

$6 2 lbs. 8 lbs.

The price that clears the market (i.e. makes supply equal to demand) is $4. If the

suppliers start out with an asking price of $6, the consumer will buy only two pounds of carrots –

one pound from each supplier. This might tempt one supplier to drop his price to $5. The choice

that the suppliers face is shown in Figure 4.6. The key to understanding the dynamics of this

interaction is pay careful attention to the incentives that each individual supplier faces.


($3.5,$3.5)

Player 2 asking price $6 $5

$6 Player 1 asking price $5

($6.66,0)

(0,$6.66)

($3.33,$3.33)

Buyer purchases all carrots from supplier with lower price

price

quantity

1 2 3 4 5 6 7 8

8

7

6

5

4

3

2

1

S

D

At $6, 2 units are bought, generating a supplier's surplus worth $7.

At $5, 3 units are bought, generating a supplier's surplus worth $6.666.

Buyer purchases from both suppliers, who split the surplus

Figure 4.6 Competition among suppliers

The only equilibrium of this game is for each supplier to charge $5. The reasoning behind

this is straightforward. No matter what the other supplier does, you can always do better

charging $5. If he asks for $6, then you could split the $7 surplus with him by charging $6 as

well, or you could steal all of his business away, and thereby capture the entire supplier's surplus,

by charging $5. Of course, lowering the price reduces the size of this surplus. But the fact that

you get all of it, rather than half of it, is enough to outweigh the loss. On the other hand, if your

opponent is going to charge $5, then the size of the surplus is going to be smaller regardless of

what you do, and so it's best to ensure that you get your share of the market. As a result, it is also

in your interest to charge $5. So either way, you should reduce your price to $5.


Thus the two suppliers are stuck in a classic prisoner's dilemma. High prices generate a

relative “scarcity” of customers (by reducing demand below the level of voluntary supply). This

in turn forces suppliers to compete for customers, by offering lower prices. Thus both will reduce

their price from $6 to $5, despite the fact that this reduces the total size of the suppliers’ surplus.

This competition continues until customers are no longer scarce, which is, of course, the point at

which supply and demand curves intersect. (Thus the suppliers are not just stuck in a prisoner’s

dilemma, but rather a race to the bottom)

This example shows how, when prices start above the market-clearing level, competition

between sellers has the effect of driving these prices down.

• Price starts at $3. The situation that arises when the price starts out below the market-clearing

level precisely mirrors the one in which it starts out above, except that this time it is consumers

who begin to compete with one another instead of suppliers. At $3 per unit, consumers would

like to buy 5 units of the good, while suppliers are only willing to sell 2. Thus the good will

become scarce (which is also to say that there will be "pent-up" demand – not everyone who

wants to buy the good will be able to get some of it). The big question then becomes who will get

left out (or equivalently, who gets what portion of the consumer's surplus). This presents each

consumer with an opportunity. Rather than run the risk of getting stuck with nothing, he could

offer the suppliers slightly more than the going price. The losses that he suffers from paying

more will be outweighed by the fact that suppliers will not run out of the good before he gets

some. This competition among purchasers drives prices up toward the market-clearing level. At

that point, all of the consumers get as much as they want, so there is no reason for them to

compete with each other any further.

Incidentally, the competition among sellers and among buyers can take a variety of

different forms. For example, the competitive dynamic can be seen in the way that "sales" are

managed in the retail sector. Many retailers start out pricing things a bit high, then put them on

sale when it looks as if they will not all sell. The kind of competitive price-cutting that may

result is quite visible. Competition among consumers is considerably less visible. Consumers

effectively compete with one another by buying things before they go on sale. That is, many

consumers will not pay full price for a good if they expect it to go on sale in a month or two.

Naturally, if everyone waited, then things would go on sale. But if people think the seller will run


out of the good, they will buy it at full price rather than risk waiting. (This is why people who

wear common clothing sizes often wind up paying more for them. Since retailers tend to sell out

of certain sizes very quickly, people who wear those sizes generally cannot afford to wait around

for sales.)

This example shows clearly how both suppliers and consumers face a collective action

problem. Each consumer who holds off on a purchase in order to wait for a sale produces a

positive externality for other consumers, in the form of increased pressure on suppliers to lower

the price. Similarly, each supplier who delays putting things on sale produces a positive

externality for other suppliers, in the form of increased pressure on consumers to buy at that

price. In both cases, this generates a free-rider incentive – consumers may "break ranks" and buy

at full price, or suppliers may "break ranks" and have a sale. The consequence of these two

collective action problems will be downward pressure on the price of plentiful goods, and

upward pressure on the price of scarce goods. The only equilibrium will be the point at which the

amount of the good exchanged is just right. Markets will clear, and the resulting allocation will

be Pareto-optimal. (It takes a bit more work to show that a Pareto-optimum can be achieved

across all markets simultaneously. This issue will be returned to in §5.2.)

4.5 Markets and Production

Let us return to the original distribution problem. You were the chief, charged with the

task of distributing out the vegetables from your village's garden. You realized that instead of

trying to devise a distribution system that perfectly matched people's preferences, you could just

create a market in which the people could exchange their goods until everyone's preferences

were best satisifed. This was done for pragmatic reasons, but now, as your economic advisor

points out, you have inadvertantly created for yourself a new source of information about your

people's needs. In order to directly distribute out vegetables to people in accordance with their

needs, it would have been necessary to get everyone to fill out a questionnaire detailing all of

their likes and dislikes, and the intensity of these preferences. Collecting this information would

have been extremely time-consuming, and furthermore, there is no guarantee that the preferences

people report would be genuine. The market, however, by achieving a Pareto-optimal allocation

of goods, has the effect of disclosing these preferences – it is what game theorists call a


revelation mechanism. Much of the basic information that you could want about people's

preferences is contained in the prices at which the various markets clear.

These prices might reveal interesting things. For instance, suppose that even though the

garden produces exactly the same quantity of potatoes, carrots and corn, a pound of potatoes or

carrots sells for twice the price of a pound of corn. This must reflect the fact that, on average,

people like potatoes and carrot more than they like corn. A taste for potatoes makes them less

willing to sell their share, thereby reducing the supply, but also more eager to buy, thereby

increasing the demand. The result is a higher price for potatoes. Thus using a market to allocate

goods creates a set of prices that reflects the underlying system of needs. The key difference is

that while needs are unobservable, prices are publically available. Prices are therefore like a

visible image of an invisible preference structure (like the way an infrared camera uses the

visible spectrum to represent light waves that we cannot see). Naturally, this image may be more

or less accurate, depending upon how "perfect" the market is (more on this in the next chapter).

A big advantage of prices, however, is that because they rely upon the actual transfer of goods to

reveal preferences, agents have no incentive to misrepresent their needs. When filling out a

questionnaire, there is no reason not to say that you want something more than you actually do.

But in a competitive auction, there is good reason not to bid more than you actually want to pay

-- you may wind up having to pay it!

Now that prices have made this information available, a new opportunity for improving

the well-being of the village presents itself. You begin to think, "perhaps we don't need to grow

so much corn, maybe we should plant more potatoes and carrots next year." Exchange may

improve allocative efficiency, but this does nothing to improve productive efficiency. If nobody

really likes corn, then it may not make any sense to grow it. Redeploying the resources used to

grow corn into potato or carrot production could make everyone better off. As the leader, you

have the power to make this kind of decision. However, deciding exactly how much land should

be switched over can be a tricky matter, involving a complex set of calculations.

Once you start thinking about it, you realize that not only your land, but some of your

other resources may be misallocated as well.* For instance, everyone in the village takes turns

working the whole field, but some people are better at some jobs than others. Despite the fact

* I use the term goods to refer to material that is used to satisfy preferences, and resources to refer to material used to

produce goods. Economists sometimes use the term products instead of goods, and factors instead of resources.


that Susan is a very good potato-digger, while Fred is an expert in dealing with carrots, both of

them are taking turns doing both jobs. It would be better to have Susan focus on potatoes, and

leave the carrots to Fred. But deciding who is better at what, and dividing up the work to

everyone's satisfaction, would also be a costly and time-consuming business.

Again, your economically-inclined advisor intervenes. Instead of managing the allocation

of resources for the whole farm, she suggests, then giving everyone an equal share of the

vegetables, why not give everyone an equal-sized plot of land? Take the collective farm, divide it

up into individual plots, and give it away. Let people grow whatever they want on their own

plots, and then exchange their produce as they see fit. When the price of some vegetables is high,

this gives everyone an incentive to grow more of those vegetables (either to sell them, or to avoid

having to buy them). If some people are especially good at tending particular crops, they can

specialize in that area, then exchange their produce with others. Everyone can do their own cost-

benefit calculation to see how much of each type of vegetable they should grow. People may

grow vegetables for their own consumption, or they may grow vegetables that they intend to sell.

(Suppose that Susan wants to eat carrots. There are now two ways that she can obtain them: she

can grow carrots herself; or she can grow something completely different, in order to exchange it

for carrots. If she can get more carrots using the latter strategy, then she will do so. As a result, if

there is a shortage of potatoes, relative to carrots, resulting in a higher price for potatoes, Susan

can be expected to shift production into the potato sector (since it has become more attractive for

her to buy carrots, with the proceeds of her potato sales, than to grow them directly). She thereby

solves the problem for the potato-lovers as a way of obtaining more carrots for herself. More

generally, as long as everyone is trying to get the most that they can out of their plot, i.e. to get

the best possible bundle of vegetables for themselves that they can, then the resulting level of

consumption will be both allocatively and productively optimal. All of the resources will be put

to their best use, and all of the goods will be the hands of those who want them most.

What the advisor has just suggested is the basic structure of a laissez-faire economic

system – the state assigns property rights, then leaves everyone free to make their own decisions

about what to do with their share. The "moral economy" is eliminated not just from distribution,

but from production as well. The primary impact of this change is upon the supply curves of

those selling goods. In the situation where everyone received a fixed share of the vegetables

produced in the garden, and then exchanged them, the opportunity cost of selling a particular


vegetable was simply the owner's own foregone desire for it (selling a potato means that you

don't get to eat it). But in the case where everyone recieves a share of the resources needed to

produce these goods, the opportunity cost of selling a particular vegetable is the owner's own

desire for it or for any other bundle of vegetables that could have been produced with the same

resources. Selling a potato means that you have used some of your land, and some of your time,

to grow a vegetable that you end up eating. This has the effect of changing the supply curves for

each good in such a way as to reflect this opportunity cost.

Take the following example. Suppose the collective farm produces exactly the same

amount of potatoes and carrots, and that the two vegetables sell for the same price. This reflects

the fact that, in the aggregate, people are just as fond of potatoes as they are of carrots. But

suppose also that it takes twice as much land to produce one pound of potatoes as it does to

produce a pound of carrots. In the moral economy, this will have no impact upon the supply

curve for either product, because these curves are determined only by people's desire to consume

carrots and potatoes. Since people are, in the aggregate, indifferent between the two, the supply

and demand curves will be the same. Figure 4.7 illustrates the fact that the opportunity cost of

one pound of potatoes is the same as that for one pound of carrots.

price

x0

p0

D

S

quantity

Supply of carrots and potatoes

lict of

Demand for carrots and potatoes

lict

Figure 4.7 Supply and demand with a moral economy

Things change significantly, however, when the land is distributed out to the farmers.

Now everyone is in the position of choosing what type of vegetables to grow on his or her land.


They will not have enough space and time to grow everything that they want, and so everything

that is planted has its own opportunity cost. For instance, using a plot of land to grow potatoes

means that one cannot use it to grow carrots. But since potatoes require twice as much land as

carrots, this means that the opportunity cost of producting one pound of potatoes is in fact two

pounds of carrots. Thus people's willingness to grow potatoes is not the same as their willingness

to sell potatoes that are given to them. So while the market demand curve will remain the same,

the supply curves will change, as shown in Figure 4.8.

price

x0

p0

p1

x1 x2

p2

quantity

Supply of potatoes

lict of inte

Demand for carrots and potatoes

lict

Supply of carrots

lict of i

Figure 4.8 Supply and demand with a market for resources

Because potatoes take up more space, as long as the price of carrots and potatoes is the

same, some producers will decide to grow just carrots, and buy their potatoes on the market. As a

result, the supply curve for potatoes becomes steeper and the supply curve for carrots becomes

gentler. This reflects the fact that, at any given price level, producers are willing to supply more

carrots than they are potatoes. The consequence is that the number of potatoes produced will fall,

and the number of carrots produced will increase, until a new price equilibrium is reached.

However, since every plot of land freed up from potato production produces twice as many

pounds of carrots, the sum of consumer's and supplier's surplus will be larger than under the

moral economy (i.e. the area of the two triangles formed by the supply and demand curves in

Figure 4.8 is larger than twice the area of the equivalent triangle in Figure 4.7).

Exactly the same logic applies to the case of goods that are more labour-intensive. If

producing potatoes is more work than producing carrots, this will make producers even more


reluctant to grow them, making the supply curve even steeper, and therefore making the

equilibrium price higher. The same goes for goods which require more seed, or which require

special equipment to plant, and so forth. In general, the supply curve for any particular good will

be determined by the opportunity cost of the resources required to produce it. This means that the

price of a good, when there is a market for productive resources, will be determined by the

demand for that good, along with the cost of producing it. As a result, productive resources will

tend to flow to their best employment. People will only produce goods that cost a lot in resources

to produce if the price warrants it, i.e. if they are in severly short supply, or if some people really

want them. As a result, the price system imposes something like an ultra-finegrained rationing

system on productive resources, so that they are only employed where demand warrants it.

Why does this generate a Pareto-improvement? One way to think about private property

and markets is to treat them as a mechanism that internalizes a certain class of externalities.

Growing food generates a positive externality, in the sense that after I have grown it there is

more food in the world than there was before I grew it. Having a property right to this food

allows me to "capture" this positive externality, transforming it from a social good into a private

benefit. Eating something, on the other hand, generates a negative externality, in the sense that

there is now less food in the world than there was before I ate it. The fact that I must acquire a

property right to what I eat in order to eat it means that I must bear the cost of this externality.

Thus the system of property rights ensures that my individual consumption reduces no one's

stock but my own. It "internalizes" the negative externality.

However, in the case in which the products of the vegetable garden are simply distributed

out to everyone, not all of the externalities generated by consumption are fully internalized. If I

simply eat what the chief gives to me, my consumption decisions do not take into account the

relative scarcity of the goods that I consume. As a result, I need not take into consideration how

much other people might like to eat the vegetables that I have. This means that my consumption

decisions may generate externalities for others, in the form of decreased availability of goods

that they want. For example, I may eat a carrot that I am given, even though I am not particularly

fond of carrots, and would have been just as happy with corn. But in so doing, I may deprive my

neighbour, who is allergic to everything except carrots, of a precious source of food. Thus

individual acts of consumption generate negative externalities for others, in the form of

decreased opportunities for consumption. What a market for consumption goods does is force


everyone to fully internalize this class of externalities. If other people really want carrots, this

will be reflected in a higher price for carrots. As a result, instead of just choosing to eat a carrot

instead of corn, I will be choosing to eat a $2 carrot instead of a $1 corncob. The higher price

reflects the fact that others value the carrot more highly than I do, and so I have to "pay" a higher

opportunity cost in order to eat it. The price of my consumption is, in effect, the cost to society of

the loss of a carrot.

But as long as this market just governs distribution, there will still be an important class

of negative externalities generated by acts of consumption. Eating a carrot or a potato generates

costs to "society" in terms of the resources used to produce that vegetable. If potatoes take twice

as much land to grow as carrots, then eating a potato instead of a carrot consumes more

resources. However, when everyone is simply given a bundle of vegetables at the end of the

season, these resource costs are not reflected in the price. This means that people with tastes that

require more resources to satisfy can consume just as much as people whose tastes require fewer

resources to satisfy. Since the cost of producing any particular vegetable is borne by society as a

whole, individuals have no incentive to consume vegetables that require fewer resources to

produce, because the higher cost of production is not reflected in the price. Creating a market for

resources, and allowing individuals to produce their own goods for exchange, has the effect of

internalizing this class of externalities as well. The price of a good, under this arrangement, will

reflect not only how much demand there is for that good, but also how much demand there is for

the resources used to produce it. Thus individuals are forced to pay the full price to society not

just of the loss of a carrot, but of the land, labour and other resources used to produce that carrot.

The reason that creating markets for allocation and production generate Pareto-

improvements should now be obvious. They eliminate waste. Waste occurs if someone consumes

a scarce good, when he would have been just as satisfied with a plentiful one. Waste occurs if

someone uses scarce resources to produce goods that no one particularly wants, when he could

have used them to produce goods that people do want. The market transforms scarce goods into

expensive goods, scarce resources into expensive resources, then makes everyone pay for the

goods they consume and the resources they employ. The only people willing to pay this price are

those who really want the good, or who can put the resource to best use. All of the others will

shift their consumption into cheaper goods or resources. As a result, the set of goods and

resources will be perfectly matched to the needs and capabilities of their owners, and so there


will be no way of rearranging allocation in order to improve someone's condition without

worsening someone else's.

4.6 The Invisible Hand Theorem

Pretty much every society in the world has dabbled with competition here and there as a

way of getting people to increase their economic productivity, and almost every society has

engaged in some sort of trade. Many societies have even put the two together in order to produce

markets for particular goods. The blueprint for capitialism, however, calls for competition on an

entirely different scale. What the English philosophers suggested was that society should take the

whole thing – the whole economy – and turn it into one big competition. Competition was

already being used to get people to work harder, to produce better goods, to find better prices,

and so forth. What if this competitive mechanism could be integrated into the economy at every

level? In other words, what if all production, distribution, consumption and investment were

handled on a competitive basis? People could compete with each other to produce the best goods,

merchants could compete with each other to bring these goods to the markets where they are

most needed, consumers could compete with each other to purchase the most desirable goods,

and producers could compete with each other to get access to any surplus left over for

investment.

But while this might sound good in theory, organizing this kind of competition could

prove difficult in practice. What kind of institution, or set of rules, could do the job? Many

competitive sports have incredibly complicated rules. Yet in the case of the economy, the answer

proved to be surprisingly, even alarmingly simple – an exclusive property right. This idea

emerged out of the social contract tradition, and was given its classic formulation by Locke.

Traditionally, European societies did not clearly distinguish economic from political entitlements

(the term "dominion" was used to refer both to economic ownership of land and political

sovereignty over its inhabitants). Property rights, such as they were, tended to be of an inclusive

variety. This mean that people had a right to be included in cooperative arrangements, e.g. a

peasant had a right to graze his cow on the commons, or to work a portion of the feudal lord's

land. (Much in the way that what we now think of as political rights are largely inclusive, e.g. the

right to vote, to reside in the country, and so on). The inclusive right is well suited to a moral

economy or hierarchy, i.e. it specifies who belongs to the community, and so who should be


accorded the obligations and entitlements that accompany membership. What Locke proposed

was a perfect inversion of this traditional conception of right. A property right, he suggested,

should be a right to exclude anyone else from using some object or territory. Having a right to a

piece of land, in the old inclusive view, meant that no one could stop you from using it. Having a

right to a piece of land, according to the new view, meant that you could stop anyone else from

using it (see Tully 1980).

This might seem like a small difference, but its consequences were significant. One of the

things about exclusive property is that it can be bought and sold (or “alienated”) at will. Since the

owner is free to dispose over it as he sees fit, he can give it away or trade whenever he likes.*

(Since the right is exclusive, it is nobody else's business what he does with it.) This is a major

innovation, because all of the major productive assets under feudalism were not for sale. Usually,

because all sorts of people would have inclusive rights to a particular thing, no one was free to

dispose of it without the consent of all (and even then, not always). In particular, land could not

be bought or sold, ownership of land could only be transferred through inheritance or royal edict

(hence the term "landed aristocracy" – the aristocracy was just the class of people who owned

land). Thus the new exclusive conception of property rights gave individuals the ability to

dispose over all of their possessions however they liked.

With this conception of right in place, Locke went on to argue that anything that a person

invests his labour in, including land that he improves, automatically becomes his property (his

argument for this was presented in §1.4.). Since all of this property can be freely traded, the

individual can use the products of his labour to purchase the products of anyone else's. This

means that as long as people respect each other's property rights, the only way to improve one's

holding is either through direct labour, or by exchanging the products of one's labour for those of

someone else. If this system of rights is in place, Locke argued, people can be left free to

compete for material possessions. Let them build whatever they want, accumulate as much as

they want, trade as much as they want – everyone will be better off. As long as the system of

property rights is in place (along with the basic provisions of criminal law – you can't kill, maim

or unreasonably restrict other people's liberty), unregulated competition for individual

accumulation and consumption will generate efficient outcomes.

* I say "he" because women were not allowed to hold this kind of property in England until the late 19th century.


Initially this doesn't sound right. If individuals are free to appropriate as much as they

can, produce as much as they can, won't this lead to waste? The key to avoiding this, in Locke's

view, is exchange. As long as people are free to exchange any surplus goods for things that they

want or need more, everyone will benefit. Private ownership of land and its produce gives me an

incentive to get as much land as I can, and to cultivate it as intensively as I can. But even if I take

a huge piece of land, and grow much more corn than I need to feed myself, I'm not going to let it

rot. Instead, I will find someone who needs corn, and then exchange it for something that I do

need. In this way, my labour will have "increased the common stock of mankind," and so

benefited others. Rather than just growing enough corn for myself, I will have grown enough for

me and some others. Evidence for this claim, Locke suggests, can be found in the comparison

between England and North America at the time (i.e., the 17th century). Although an acre of land

in both places has the same "intrinsic value," land in England is largely divided into private

property, and so is much more intensively cultivated. As a result, "a king of a large and fruitful

territory [in America] feeds, lodges, and is clad worse than a day labourer in England" (1689,

§41).

This conception of property rights was Locke's major contribution to political economy.

Unfortunately, the arguments that he used to defend this system of rights were less than

conclusive. There is, in Locke's system, a missing argument. He needs to show, in order to

achieve his stated goal, that a system of private property rights will generate Pareto-

improvements – that it will be efficient. In order to do this, he must show that, in principle, no

one will be harmed. He is able to argue convincingly that, at the beginning of time, when there

were vast tracts of land sitting unused, individual appropriation would generate no harm, because

there would be "enough and as good left for others." But he does not show that when land starts

to run out, those who have more limited opportunities will not lose out under the private property

system. He claims that these individuals will automatically be compensated through the

exchange mechanism – because labour is the source of the value that resides in property, these

individuals can still exchange their labour, or the products of their labour, for anything produced

on the land. As a result, there are unlimited opportunities for accumulation, and so no existing

accumulation diminishes anyone else's opportunities. But he is not able to show that this

compensation will occur. This is equivalent to saying that he is not able to prove that markets

will be efficient, or that the competition created through the introduction of exclusive property


rights will work properly. The rules may not guarantee that the positive externalities generated

through the competition will outweigh the negative ones. We can call this Locke's "missing

argument."

The above discussion provides a powerful intuitive case for the claim that "deregulation"

of normatively integrated spheres of action can produce efficiency gains. However, the examples

all rely upon someone taking an active role in assigning particular property rights to individuals

– either by giving everyone a bundle of vegetables, or everyone a plot of land. Exchange is then

used to produce Pareto-improvements upon this initial allocation. But this does not fill the gap in

Locke's argument. There is no reason, according to the view developed so far, that the leader

could not divide up the all of the land among the villagers at the beginning of each new growing

season. In this way, individuals would only "own" their land for a year, after which they would

be assigned a new plot. In fact, this can easily seem to be the only efficient way to proceed. After

all, if the land is distributed out "once and for all," this means that anyone who is born after the

initial distribution will be excluded from access to all productive resources (whereas with an

inclusive right they would automatically get the same share as everyone else). Thus the shift

from a collective farm to a system of property rights would harm those who do not get a piece in

the original allocation. This would prevent such a change from being Pareto-efficient.

This type of consideration is what motivated, for example, the Northern Wei kingdom in

5th century China to develop the so-called "equal field" system of land distribution (later made

official policy for all of China by the Sui, and retained for the first 200 years of the Tang

dynasty). According to the original Wei system, each family received a basic allocation of 20 mu

of inheritable land for growing trees, plus 40 mu of non-inheritable crop land for each able-

bodied man in the household, 30 mu for each ox. Whenever the number of men or oxen declined,

their portion of the land reverted to the state, which redistributed it to families whose number of

men or oxen had increased. In this way it was guaranteed that land was held only by those who

could make productive use of it, and that everyone who could make productive use of land had

access to it. Thus new people who came along or young people who came of age would not lose

out. This would appear to guarantee an efficient outcome, but it is very far from the sort of

laissez-faire system favoured by the English philosophers.

In Locke's view the earth was divided upon among all living persons in a stage of "initial

appropriation." Once this initial appropriation had ended, property can only be transferred


through voluntary exchange. Thus the government, according to Locke, is not entitled to either

assign or reassign property rights. The problem this creates, however, is that in order to

participate in voluntary exchange, a person must have something to offer. If some people get

nothing in the initial appropriation, they will have nothing to offer, and so they will have no way

of getting their foot in the door of the property system (unless someone happens to give them a

gift or an inheritance). Setting aside issues of fairness – there is no presumption that any of the

allocations discussed here are fair – the big problem is that a "once and for all" allocation of

property rights seems to generate winner and losers. If it generates losers, then these people

cannot reasonably be presumed willing to consent to such a system. This suggests that in order to

maintain efficiency, the state must be commited to a constant redistribution of property rights, so

that everyone will be included. This is a conclusion that Locke (and, needless to say, most of the

property-owners in England at the time) sought to avoid.

People who begin life without an initial property endowment used to be referred to in

English political economy as the poor (those who we now refer to as poor were then called

paupers). One way of stating Locke's problem, therefore, is to say that assigning "once and for

all" property rights creates, over time, a class of people who are poor. The question is then what

incentive the poor have to respect the system of rights, if all it does is harm them. The answer

that Locke sketched out, and that Smith tried to fill in somewhat more completely, draws upon

two ideas: first, that everyone has an automatic right to at least one productive resource, viz. their

own labour, and second, that there are significant gains to be had from specialization. This gives

everyone a way of "getting in" to the property system, because people can sell their labour to

those who own the material resources. But because different people have different talents, the

sale of labour will result in greater specialization in the production process, which will in turn

yeild much higher output levels. As a result, even those who must work their way into the

property system through their own labour will benefit from the system of property rights,

because it is this system that permits the advanced division of labour.

The underlying assumption is that if individuals are given private property rights to land,

tools, and the other means of production, then markets will arise for all of these resources. In the

previous section, it was assumed that individuals all worked only on the plots of land that were

assigned to them. However, if some of them decide to plant low labour-intensity crops, they may

find themselves with some spare time at the end of the day. This may make them willing to sell


their labour to others. Similarly, if some people decide to plant crops that are very labour-

intensive, they may not be able or willing to use all of their land. They may then rent this land to

others, or else hire someone to help them work it. In this way, markets will develop for both land

and labour. This will make it possible for people who do not get a plot of land in the intitial

distribution either to sell their labour to those who did, or else rent land from them.

The prices at which these inputs sell will be determined, as before, by the level of supply

and demand. However, both the supply and the demand will be fixed in a somewhat indirect

way. In the consumer market, the level of demand for a good is determined by the number of

people who want to consume that good, and the intensity with which they desire it. Productive

assets, however, are not desired for their own sake, but for the sake of the goods that they can be

used to produce. This means that in the market for productive inputs, the person who wants a

resource the most is not the person who most wants to consume it, but the person who is able to

put it to the best productive use (this person can produce the most valuable bundle of

commodities using that input, therefore she is willing to pay the most for it).

If we assume that some people are better at some things than others, then the labour

market will tend to allocate workers to tasks that they are good at performing. For instance, if

Ted has a special talent for digging carrots, then any spare time that he has will tend to be

purchased by people who need help with their carrot farming. Because Ted is better at this task,

his labour is more productive than average, i.e. he digs up a greater number of carrots per hour.

As a result, the carrot farmers will be willing to outbid other farmers in order to secure Ted's

services. Thus competition among those who want to purchase labour services will tend to

allocate labour to its most productive uses. But when this occurs, it changes the supply curve of

that commodity, which in turn lowers the price. This generates a Pareto-improvement that is

enjoyed by consumers. We can refer to this as the gain from specialization. It occurs because

competition among producers has the effect of allocating resources, including labour, to their

most efficient employment.

Eventually, Ted may find that he is in such high demand as a carrot-digger that he can

make more money working for others than he can cultivating his own plot of land. As a result, he

may decide to sell his land and work as a full-time carrot digger. The same may be true of the

person who builds ploughs, or tends the cattle, and so on. The overall result is that the exchange

of productive resources will generate an extremely advanced division of labour. Thus Smith


argued that since "it is the power of exchanging that gives occasion to the division of labour," the

division of labour is limited only by the extent of the market (1776, 27-28). Naturally, this is not

true if it is meant to say that the division of labour can only be accomplished through the market.

Any corporation (even Smith's celebrated example of a pin-factory) has an internal division of

labour, but it is not dictated by the market. What is true, however, is that when producers

compete with one another for resources, including labour, the only equilibrium (ceteris paribus)

is one in which there are no further gains from specialization to be had. Thus markets have the

capacity to exploit the opportunities presented by specialization more effectively than most other

forms of social organization.

So how does this fit in with Locke's argument? Once markets have developed in which

productive resources are freely exchanged, people entering the property system will always have

opportunities available to them. They can either sell their labour to others, or they can rent

resources and repay the owner with the goods that their labour is able to produce. And because

these markets allow for an extremely advanced division of labour, they produce a general

cheapening of commodities that benefits every member of the society, regardless of how much

they own. Thus the property system gives people access to goods at prices much lower than it

would cost to make them one's self. According to Smith:

The real recompence of labour, the real quantity of the necessaries and conveniencies of

life which it can procure to the labourer, has, during the course of the present century,

increased perhaps in a still greater proportion than its money price. Not only grain has

become somewhat cheaper, but many other things from which the industrious poor derive

an agreeable and wholesome variety of food, have become a great deal cheaper. Potatoes,

for example, do not at present, through the greater part of the kingdom, cost half the price

which they used to do thirty or forty years ago. The same may be said of turnips, carrots,

cabbages; things which were formerly never raised but by the spade, but which are now

commonly raised by the plough... The common complaint that luxury extends itself even

to the lowest ranks of the people, and that the labouring poor will not now be contented

with the same food, clothing and lodging which satisfied them in former times, may


convince us that it is not the money price of labour only, but its real recompence, which

has augmented (1776, 96).*

Thus children need not receive a "share" of all the property in the world upon birth – in

this sense they are harmed – but they are compensated by the fact that their labour is able to

command an amount of wealth far greater than they could ever produce on their own. In many

cases, a single day's wages allow consumers to buy goods that it would take an entire lifetime to

build on their own. Based upon this argument, Locke and Smith both drew the conclusion that

the existence of poverty did not pose a problem for the operation of the capitalist system.

This argument, however, still does not cinch the case. Smith was correct to emphasize the

superior incentive effects of markets, along with the advantages that stem from the division of

labour. However, he does not show that the efficiency gains achieved through this mode of social

organization will be sufficient to outweigh the losses that the poor suffer through their initial

exclusion from the property system. As a result, he does not show that the government could not

effect further Pareto-improvements through occasional intervention and redistribution of

property endowments (as was done, for instance, under the "equal field" system). As a result, his

case for a laissez-faire market economy remains incomplete. Clearly, just as the

institutionalization of a moral economy and various authority structures can generate Pareto-

improvements over the state of nature, markets can generate Pareto-improvements over the

moral economy. But this does not show that one should entirely replace the moral economy with

a market system. What it shows is simply that the allocative or productive efficiency of the moral

economy can be improved at various points through implementation of market mechanisms.

There is, however, a way in which the case for laissez-faire can be made. If it could be

shown that a market system generated a Pareto-optimum, given existing preferences and

productive technologies, then the case against intervention would be complete. If markets

produce a Pareto-optimum, then one could argue that the system of markets should fully replace

the moral economy, because there is no way that any type of non-market intervention could

improve upon the the performance of the market economy. What it would show, in effect, is that

from the standpoint of efficiency, markets provide perfect outcomes. This claim is often referred * For a more extravagent version of the same argument, see Smith (1776) pp. 22-24. Echoing Locke, he claims here

that the accommodation of "an industrious and frugal peasant" in Europe "exceeds that of many an African king, the

absolute master of the lives and liberties of ten thousand naked savages."


to as the "Invisible Hand Theorem." (Blaug, 1985). If it is correct (and since it is impossible to

improve upon perfection), it would show that there is no role for governments, leaders, or even

morality, in the organization of economic activity.

4.7 Market Utopianism

Although Smith coined the phrase "invisible hand," he did not succeed in proving the

invisible hand theorem (he even expressed some doubts about it). However, this did not prevent

the blueprint of an argument that he offered from creating enormous popular excitement. His

vision of a self-regulating economy, in which individuals pursue their own interests, and yet

everything always works out for the best, became the basis for a very powerful utopian vision,

which remains one of the most influential in our culture. The core of this vision is best captured

in David Gauthier's claim that markets provide "freedom from morality" (1986, 83). If one had a

properly organized market society, according to this view, people would no longer have to

exercise moral constraint. It would be like never having to say you were sorry. All vestiges of the

moral economy could be abolished, including, in some versions, the state (the latter view is

referred to as libertarianism).

The idea that we might be able to dispense with morality takes as its point of departure

Smith's famous observation that "it is not from the benevolence of the butcher, the brewer, or the

baker, that we expect our dinner, but from their regard to their own interest. We address

ourselves, not to their humanity but to their self-love, and never talk to them of our own

necessities but of their advantages" (1776, 27). This same line of thinking finds contemporary

expression in the work of Ayn Rand, or in the popular understanding of Gordon Gekko's "greed

is good" speech in the movie Wall Street. From this perspective, the basis of social order lies in

self-interest, with the market providing the basic framework for social cooperation. Morality, far

from being essential to this order, is actually an unnecessary accretion that has developed over

time.

Some theorists went even further, arguing that morality was not just unnecessary in a

market economy, but positively pernicious. This led them to promote a kind of "transvaluation of

values," according to which actions that were traditionally thought to be good – like selfless or

altruistic behaviour – would come to be seen as bad (Mandeville, 1724). This view found some

encouragement in the seemingly paradoxical fact that markets do not just permit competitive


behaviour, they require this behaviour in order to function correctly. If consumers do not

compete against each other for scarce goods, but instead decide to share what is available, then

the price of these goods will not rise. As a result, producers will have no incentive to supply

more of these goods, and will not be able to command the extra resources needed to provide

them. This means that sharing and cooperation will generate Pareto-suboptimal outcomes. These

sorts of considerations are what motivate people like Rand to say that not only is selfishness

good, but that altruism is positively "evil."

The idea that altruism can interfere with price signals, and so lead to excesses of supply

or demand, was most influential in the discussion of "poor relief" in 19th century England. Since

there will only be so much demand for labour at any given time, giving charity to the poor sends

the wrong signals, making it seem as if there is more demand than there actually is. The

inevitable result is that the supply of labour will exceed the level that the economy (or more

specifically, the agricultural basis of the economy) can support. According to Thomas Malthus,

who popularized this argument, preventing the poor from starving through charitable relief just

means that they will have to die in some other way:

All the children born beyond what would be required to keep up the population to this

level must necessarily perish, unless room be made for them by the deaths of grown

persons... To act consistently, therefore, we should facilitate, instead of foolishly and

vainly endeavouring to impede, the operations of nature in producing this mortality; and

if we dread the too frequent visitations of the horrid form of famine, we should

sedulously encourage other forms of destruction which we compel nature to use. Instead

of recommending cleanliness to the poor, we should encourage contrary habits. In our

towns we should make the streets narrower, crowd more people into the houses, and court

the return of the plague. In the country, we should build our villages near stagnant pools,

and particularly encourage settlements in all marshy and unwholesome situations. But

above all, we should reprobate specific remedies for ravaging diseases; and those

benevolent, but much mistaken men, who have thought they were doing a service to

manking by projecting schemes for the total extirpation of particular disorders (Malthus

1798, §5).


It was reflections of this sort that earned economics the reputation as "the dismal

science." A somewhat more moderate view holds that the market is efficient, and as such, allows

some people to do much better than others. Those who are naturally stronger will rise to the

surface. This in turn generates resentment and envy among the weak, who invent something

called morality in order to "guilt-trip" the strong into giving up some of their rightful

possessions. As a result, there is nothing mandatory about fulfilling moral obligations, since

morality is just a mechanism through which the weak expoit the strong. This idea – that morality

is some kind of plot devised by the inferior – is a very old one (and one which has always been

tempting for members of cultural elites). It is given forceful expression by Thrasymachus in

Plato's Republic. Since we all experience morality as something that constrains our self-interest,

it is naturally tempting to believe that we could be happier if we had the courage to move

"beyond good and evil," and simply do whatever strikes our fancy. However, Socrates's response

to Thrasymachus is precisely the right one – what you perceive to be your self-interest is actually

just a free-rider incentive, and so the constraint that morality imposes upon your capacity to

pursue this self-interest is one that ultimately benefits you and everyone else. As Socrates put it,

without such constraints people "split into factions, and feud with one another," which in turn

renders them "incapable of any joint action" (1941, 35 [351]).

However, the discovery of the market pattern of organization prompted many people to

reexamine this answer. People began to think that self-interest was perhaps not as bad as

Socrates claimed. Of course, all that Locke's arguments showed was that social integration could

be achieved with only minimal moral constraints. However, many people jumped to the

conclusion that social integration was possible with no moral constraint. The standard strategy

for advancing this claim was to naturalize the system of property rights. Locke himself was not

immune to this temptation. In the Second Treatise on Government, in which he introduced his

theory of property, he also argued that the system of rights simply reflected a divinely ordained

"natural law." As a result, he claimed that the state of nature would take the form of a market

economy, instead of a Hobbesian war of all against all. However, Locke still recognized that

without this divine law, the state of nature would degenerate into a Hobbesian state of war.

Subsequent thinkers tried to argue that the system of rights would emerge "spontaneously"

through self-interested action, or that people were just "naturally" inclined to respect each other's


property. This led them to a somewhat utopian faith in the power of individuals to get along in

the absence of moral constraint.

This brand of utopianism finds its primary expression in the the idea that markets are

somehow more "natural" than other kinds of social institutions. According to this view, a moral

economy, or a state-centered system of production, represent an artificial deviation from the

natural pattern. As a result, if these institutions are eliminated, people will quickly "revert" to the

market pattern of organization. According to this view, it is not necessary to construct a market,

all that policy-makers need to do is remove the barriers that prevent natural competition form

emerging. This pattern of thinking was obvious in much of the advice given by Western

economists to former communist states seeking to make a transition to capitialism. What many

of them said amounted to: "you don't need to do much, just dismantle your existing economic

institutions and markets will automatically spring up to take their place." As a result, many of

these countries began privatizing portions of the state sector without first establishing a proper

regulatory apparatus. The predictable consequence was, rather than a spontaneous formation of

markets, simply an explosion of crime and corruption.

An example may help to illustrate this point. Shortly after the privatization of agriculture

and food production in Hungary, the country was swept by an epidemic of lead poisoning. After

searching far and wide for the cause, doctors and scientists finally found the source of the

problem. Manufacturers of paprika – a staple of Hungarian cuisine – had been adding ground-up

paint, much of it lead-based, to the spice in order to improve its colour. It turned out that a

significant percentage of the paprika in the country was tainted with dangerously high levels of

lead. No laws were in place to prevent this, simply because it had not occurred to anyone that

this kind of thing would happen. Under state socialism, in which firms had no competition, no

one had any incentive to poison their customers in order to acquire market share, and so

consumer protection laws were non-existent. In making the transition to the market, policy-

makers assumed that producers would compete with one another to produce the best-quality

paprika. They didn't realize that producers would compete only to produce the best-looking

paprika. Poisoning one's customers is, from that standpoint of the firm, a negative externality.

Without consumer protection laws, product inspectors, and a court system designed to handle

liability cases, there is no mechanism to internalize this externality. But this is a fully predictable

consequence of competition. Anyone can see how naive it is to think that athletes will voluntarily


refrain from taking steriods because, in the long run, they're bad for one's health, or for the sport.

But it is just as naive to think that companies will voluntarily refrain from poisoning their

customers just because, in the long run, it's bad for the firm, or for society. To imagine otherwise

is to fundamentally misunderstand either the structure of competition or the nature of humanity.

The truth is that a market is a finely tuned legal and moral system that evolved over

hundreds of years. It is not a natural condition, but an extremely sophisticated institutional

construction, one which requires constant monitoring and enforcement. The system of property

rights alone requires a massive legal-bureaucratic apparatus just to keep track of who owns what

and who owes what to whom. Consumer protection laws, which establish the basic rules

designed to ensure that competition remains "healthy," are also an enormous legal apparatus. (It

was estimated, for instance, that after the "velvet revolution" the Czech Republic needed to pass

55,000 laws in order to get its product standards up to minimum European Union levels.)

Furthermore, since producers have a constant incentive to find new ways of externalizing costs,

the number of regulations must increase every time someone finds a more ingenious way of

circumventing the old ones (in the same way that the number of rules governing drugs in sport

increases every time someone finds a new way of cheating).

It is important, therefore, to always maintain a balanced view of markets. There is

something extremely elegant about the way that markets allocate goods and resources, and the

way that the price system automatically adjusts the system of production in response to changes

in demand. There is a clear sense in which markets achieve a level of coordination and efficiency

that no other form of social organization is able to achive. However, markets are not magical,

and they will not solve all of our problems. They work properly under very specific institutional

conditions, and they require constant monitoring.

Key words

aggregate demand

aggregate supply

allocative efficiency

competition

consumer's surplus

deadweight loss


demand

exclusive property right

gain from specialization

gain from trade

investment

laissez-faire

market-clearing

opportunity cost

price

productive efficiency

property rights

revelation mechanism

satisficing

supplier's surplus

supply

Documents

Chapter 4. Markets - University of Torontohomes.chass.utoronto.ca/~jheath/text/MMch4.pdfChapter 4. Markets The fact that ... interests of others in order to ruthlessly further their